The Costs of Credit

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INTRODUCTION

"Will that be cash, check, debit, or credit card?" You probably heard that question the last time you or your parents made a purchase at the store. What is the difference? Is using credit the same as paying with cash? Or by check? Or by debit card?

Some young people believe that using credit is the same as paying with cash. In fact, some young people believe that all you need to make purchases is a credit card. It seems as if a credit card can pay for anything-and everything.

But how you pay for things does make a difference. In this lesson, you will learn how using credit differs from paying in cash, by check, or by debit card . You will learn why credit has costs, and what the influences are that affect the cost of credit.

TASK

In this lesson you will indicate how using credit differs from using cash, checks, or debit cards, list the determinants for the demand for and supply of credit, indicate why credit has a cost, and given an interest rate, principal, and period of time, determine simple interest.

PROCESS

Voluntary Exchange and Cash Methods of Payment

When you make a purchase, you are participating in a voluntary exchange. It is an exchange because the purchase involves giving up something of value (generally, money) in order to get an item or service. It is voluntary because you don't have to make the exchange. You make it because you've decided you'd rather have the item or service in question than the money you pay to get it. (If you did not value the new item or service over the money involved, would you make the purchase?) The seller in turn is willing to accept something of value (such as cash) in exchange for the item or service he or she provides. In any economic system, voluntary exchange occurs when both parties feel that they are better off after the exchange.

Before money came into use, people traded one item or service for another. For example, one farmer who grew vegetables might have traded corn and potatoes for wool from a neighbor who raised sheep. This is called bartering. As economies and commerce became more sophisticated, however, people developed money as a medium of exchange. The use of money made trade easier. Sellers would accept money for goods and services because the money had value to them. What value? They could use money themselves to buy items and services they wanted to have.

In our society today, exchanges involving money can be made in several ways: by the use of cash, a check, or a debit card. In all three cases, buyers are paying for the item or service right away. Cash gives the seller something of value (the money) at the time of purchase. A check does the same thing--except that the money then goes from the buyer's checking account to the seller. When you write a check, you tell your bank, in effect, to pay a certain amount of money from your account to the seller. Notice the line on your check that says "pay to the order of," which indicates who will receive the money. A debit card works in much the same way. When you use a debit card, you tell your bank to transfer money from your account to the seller's account. The transfer is made electronically, not by means of a written form authorizing the exchange. In the case of payment by check or debit card, it is assumed that the buyer has enough money in his or her account to cover the purchase.

Credit and Its Use in Voluntary Exchange

Even if you are not involved in a world of high finance, you probably have some experience with credit. Have you ever borrowed money from a friend to buy a lunch or a snack? Or have you ever loaned money to one of your friends? In either case, did the lender (the person loaning the money) expect to get his or her money back? Sure. In both cases, credit was involved.

Payment by credit is quite different from the cash payment methods mentioned earlier. With credit, a promise to pay later is a part of the voluntary exchange. If the seller extends credit to the buyer, the buyer gives a promise of payment in exchange for the items he or she buys. If credit is provided by a third party (someone other than the seller), the seller receives full payment for the item, but in that case the seller still must pay money back to the third party who provided the loan. In this way, the person receiving the loan of money (borrower) is delaying payment. By contrast, a buyer who pays by cash, check, or debit card makes the full payment at the time of sale.

Many people use credit--to buy cars and houses, to pay for meals at restaurants, even to make small purchases without having to use cash. Because the use of credit is so common, it might appear that credit is unlimited. But this isn't true. Lenders sometimes deny credit to people who seem likely to have trouble paying off their debts. Also, people who do obtain credit are subject to credit limits, meaning that they can only get so much credit. (These limits are usually based on the borrowers' levels of income.) So, although credit can be very useful, the idea that it can automatically provide you with everything you want is not true.

Credit Has a Cost

People who provide loans generally want to get some return for lending money. The return they expect to receive might be compared to the rent some people pay to use an apartment that belongs to somebody else. But the "rent" we pay to use someone else's money is called interest.

Three factors can affect the amount of interest that a borrower pays for a loan. First, the amount of interest is affected by the principal--the amount of the loan. For example, if you borrow $4,000 from the bank to buy a used car, the principal on your loan would be $4,000. Second, the amount of interest is affected by the time it takes the borrower to repay the loan. This makes good sense. If you live in an apartment for two months rather than one month, you will pay more rent. Similarly, if you take out a loan for a two-month period rather than one month, you will pay more interest. Third, the amount of interest is affected by the interest rate charged for the loan. The rate is usually stated as a percentage, and it is applied against the principal of the loan. In other words, the lender wants to receive repayment of the principal plus a given percentage of the principal-e.g., five percent, seven percent, or ten percent--in interest. You will see in the tables to follow the annual percentage rate that is the cost of credit on a yearly basis. Obviously, the higher the percentage rate, the higher the amount of interest. The higher the amount of the loan (principal), the higher the amount of interest paid at a given interest rate.

Interest rates vary for various types of loans. For example, interest rates on loans for the purchase of new cars differ from those for the purchase of used cars. To check this out, go here
and click on Savings, Borrowing, and Today's averages. Look at the section for car loans.

Is the interest rate for buying a new car on credit higher or lower than the rate for buying a used car?

Why would this be? One reason is that a loan for the purchase of a new car is less risky for the lender than a loan for the purchase of a used car. A new car generally maintains its value better than a used car does. In case the borrower fails to make loan payments on time, the lender can take possession of the car and sell it. Because the risk is less, the lender can charge a lower interest rate.

Even for the same type of credit, however, interest rates can vary. To learn about some of the variations go to the Nerd Wallet
website. Here you can check out the interest rates associated with various credit cards for students.

Support your thinking by answering the following open ended questions:

Why might you want to know more about a card that has a "P" marked by the rate?

When might you want a credit card that has the characteristic indicated by the "X"?

Which of the credit cards would you choose? Explain your choice.

Determining the Interest

Now let's put these three ideas together to develop an idea of how the interest you pay is determined. It depends on the amount of the loan, or the principal. It depends on the interest rate. And it depends on the time during which the loan is outstanding. The simple interest formula includes all of these elements and is written as follows:

Amount of Interest

=

(Principal)

x

(Interest Rate)

x

(Time)

=

x

x

Keep in mind that the time variable is always figured on the basis of one year. This is the traditional way in which interest is figured. For example, if you gain a loan from your friend at a rate of ten percent for one year, you would pay $11 at the end of the year ($10 principal plus $l interest). The formula for figuring the interest would operate as follows:

$10 (principal)

x

.10 (rate)

x

1 (year)

=

$1 (interest)

If the loan were for only three months, you would pay only $10.25 after three months. The formula then would operate as follows:

$10 (principal)

x

.10 (rate)

x

.25 (time)

=

25 cents (interest)

Notice in this case that the slot for time is indicated as .25 because three months is one quarter of a year. If the loan were for one month, the time factor in the equation would be l/12, or .083.

What would the time factor be for six months?

For four months?

Most credit plans require the borrower to pay back the principal and interest in installments instead of making one payment of principal and interest at the maturity of the loan. For example, if you have a three-year car loan, you make monthly payments over the three years, and these payments cover the interest and principal; you do not pay it all off at the end of the three years. Even so, the three factors we have considered-- interest rate, amount of principal, and amount of time during which the loan is outstanding--still affect the amount that is paid.

In summary, paying for something with credit is very different from paying in cash, by check, or by debit card. With the cash methods, payment is made at the time of the exchange. Buying something on credit delays your payment. Credit costs an additional amount of money. The borrower must repay the amount of the loan--the principal--plus interest to the lender. Generally, repayments are made on an installment basis over the life of the loan. In some instances, one payment of principal and interest is made at the maturity of the loan. The cost of credit changes over time and varies from one lender to another. Borrowers often can affect the total amount of interest they will owe by shopping around for the best interest rate, by paying back the loan as soon as possible, and by paying off the principal of the loan earlier than expected.